Is Woolies an opportunity?

Thursday, March 21st, 2019

Woolworths’ interim result last month disappointed and the shares fell briefly before rebounding to where they were before the result: around $30. Does this mean there is nothing to worry about after all and the stock is a buy?

Not yet, in our view. Despite the numerous problems and complications revealed in the result, value in this stock remains elusive – probably because the market knows a large capital return with a franked dividend component is coming. In November Woolworths contracted to sell its petrol business for $1.725 billion and the transaction is due to complete soon. Allowing for an off-market buyback funded by the sale proceeds we cannot value the stock at more than $30 next year, where the share price is now.

It’s a dicey period for investors considering Woolworths. Our valuation assumes no further downgrades to consensus earnings when the poor interim result demonstrates poor earnings visibility. This stock is not as defensive as the market thinks it is, especially now management admits the group cannot overcome the more subdued consumer environment it expects. It sounds like a race just to stand still, with suppliers constantly pushing for price increases and a new enterprise bargaining agreement this year to inflate labour costs. Woolworths seems more committed to sustaining its hard-won reputation for price competitiveness than passing on these higher costs but still lost market share in an overall solid half for the supermarket sector. This reduces the visibility of margins, which are also probably too high as newer discount players enter the market. Second-half margins are set to fall.

BWS is travelling well but Dan Murphy’s is struggling to keep up with consumer tastes and the growing demand for convenience. Costs are set to rise to support digital and enhanced delivery options. The growth of online ordering and home delivery is great for consumers seeking more convenience but structurally weighs on margins by increasing costs and taking shoppers out of stores. It could be some time before Woolworths’ investment in digital and data boosts earnings.

The withdrawal of disposable plastic bags structurally increases stock shrinkage by encouraging shoppers to place items in their own bags in-store. It seems difficult to foresee or respond to competitor thematic promotions, with Woolworths management caught flat-footed by the runaway success of Coles’ Little Shop campaign.

On the positive side, the group’s reputation with customers continues to strengthen and supermarket sales per square metre are rising. The Metro format is resonating with customers and there are now 34 Metro stores. Despite the headwinds and problems, first half group return on funds employed was steady at 13.8 per cent. The exit from petrol improves margins and returns. The board’s confidence is clear from the five per cent bump to the interim dividend.

Big W finally achieved impressive first half comparable store sales growth of five per cent but the business is yet to break even because there is not enough earnings leverage to sales. In particular, choosing the apparel range customers want remains challenging. In coming weeks Woolworths will announce the outcomes of a review of its Big W store and distribution centre network. Expensive capital payments would be necessary to break long leases but this could also prepare the business for a potential sale. Big W could only be sold at a loss given it is unprofitable but this would also derisk the stock and improve forward profitability – as well as potentially funding another (smaller) franked capital return.

The best investment stories tend to be the simplest ones. Woolworths’ interim result revealed a complex business with many moving parts that are hard to forecast, in a fast-changing market. We are confident in management’s ability to devise remedial plans for every problem but some of these, like optimising staff rosters, are taking years to fix. Capital expenditure has been elevated for many years but shareholders are yet to see adequate returns here.

Our investment process seeks companies with improving ‘quality’: wider profit margins, better returns on assets and equity, less gearing, better conversion of earnings into cashflows, and stronger earnings growth. Woolworths already has a strong balance sheet and excellent cash conversion. An exit from Big W would improve group margins and returns but more heavy lifting remains to be done in food, liquor and online. We would rather wait for a sub-$28 entry price before adding the stock to the Clime Direct model portfolio.

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